Sebi vs economics, who will win?

Sebi has faced strong currents of vitriolic anger from mutual fund distributors and the mutual fund industry. This venom is rarely displayed in the mainstream media, but a look at comments on websites discussing the issue bares the raw fury of the industry as a whole and the distributors in specific. 

While the anger may be seen as a sign of self-preservation by a profession, there is a fundamental problem with Sebi’s regulations. The problem is that Sebi is trying to fight economics. 

The issue in brief is as follows. The mutual fund industry has three cogs to its wheel, the asset management company (AMC), the distributor and the investor. 

Over 80% of all funds are sold by distributors to investors, the balance being sold directly by the AMC. The distributors provide many valuable services and provide advice to investors and were compensated by the AMCs, who shared expenses/commissions/loads charged to investors with such distributors. 

Clearly, like any other financial product, there is mis-selling by several distributors to favour the products which generate the best commissions rather than those which were most suitable to the client. 

From June to August 2009, Sebi changed the rules of the game to curb mis-selling and conflict of interest which arises out of a distributor selling the most lucrative product. The regulator outlawed entry loads (a charge on purchase), capped exit load at 1% of redemptions (a charge on sale) which could previously have gone up to 7% and barred AMCs from paying distributors a commission out of the initial kitty. 

Distributors now need to negotiate with investors the initial commission and the amount must be paid by separate cheque to the distributor. This is of course great for investors who don’t need to shell out an inbuilt fee with their purchase and also the rule change reduces the conflict of interest of selling with the motivation of earning commissions. 

Unfortunately, the law of unintended consequences results in the product not being sold at all and the industry has shrunk dramatically since the rule change was introduced. 

So where did Sebi go wrong with this seemingly benevolent action? The answer is economics 101. Imagine going to the market to buy a packet of biscuits, and imagine a law which says the packet must be sold at cost, and that must be the cost to the retailer with a virtual ban on the manufacturer to pay the retailer any mark up. 

Now imagine that the same law says that the profit must be negotiated between the consumer and the retailer. The system is unlikely to work which is why such laws don’t exist for ordinary products. 

A version of this economics resulted in the fall of communism. The theory of getting products at cost to the consumer would result in the product not being sold, and in further consequence, the product will not be manufactured leading in turn to demand remaining unsatisfied. 

The conflict of interest exists in the market for biscuits as well, how often will a retailer sell you the product with the lowest margins? That is hardly an argument for selling at cost with negotiable profits. 

The Sebi board agenda note, which discusses the issue seems to solve the issue at hand inappropriately and uses partial material from the equivalent US law. First, the note goes into issues of transparency of commission structure, but ends up outlawing commissions instead.